Net Present Value

The net present value approach is the most intuitive and accurate valuation approach to capital
budgeting problems. Discounting the after-tax cash flows by the weighted average cost of capital
allows managers to determine whether a project will be profitable or not. And unlike the IRR
method, NPVs reveal exactly how profitable a project will be in comparison to alternatives.

The NPV rule states that all projects which have a positive net present value should be accepted
while those that are negative should be rejected. If funds are limited and all positive NPV
projects cannot be initiated, those with the high discounted value should be accepted.

In the two examples below, assuming a discount rate of 10%, project A and project B have
respective NPVs of $126,000 and $1,200,000. These results signal that both capital budgeting
projects would increase the value of the firm, but if the company only has $1 million to invest at
the moment, project B is superior.
Some of the major advantages of the NPV approach include its overall usefulness and that the
NPV provides a direct measure of added profitability. It allows one to compare multiple
mutually exclusive projects simultaneously, and even though the discount rate is subject to
change, a sensitivity analysis of the NPV can typically signal any overwhelming potential future
concerns. Although the NPV approach is subject to fair criticisms that the value-added figure
does not factor in the overall magnitude of the project, the profitability index (PI), a metric
derived from discounted cash flow calculations can easily fix this concern.

The profitability index is calculated by dividing the present value of future cash flows by the
initial investment. A PI greater than 1 indicates that the NPV is positive while a PI of less than 1
indicates a negative NPV. (Weighted average cost of capital (WACC) may be hard to calculate,
but it's a solid way to measure investment quality).

Key Takeaways

 Capital budgeting is the process by which investors determine the value of a potential
investment project.
 The three most common approaches to project selection are payback period (PB), internal
rate of return (IRR) and net present value (NPV).
 The payback period determines how long it would take a company to see enough in cash
flows to recover the original investment.
 The internal rate of return is the expected return on a project. If the rate is higher than the
cost of capital, it's a good project. If not, then it's not.
 The net present value shows how profitable a project will be versus alternatives, and is
perhaps the most effective of the three methods.

The Bottom Line

Different businesses will use different valuation methods to either accept or reject capital
budgeting projects. Although the NPV method is considered the favorable one among analysts,
the IRR and PB methods are often used as well under certain circumstances. Managers can have
the most confidence in their analysis when all three approaches indicate the same course of
action.

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